Wednesday, November 22, 2006

Color on quarter: Dell Computer (NASDAQ:DELL)

Several firms are commenting on Dell Computer (NASDAQ:DELL) after the tech heavyweight managed to surprise investors with a margin rebound last night:

- Bear Stearns is upgrading their rating to Outperform from Peer Perform saying that while Dell (NASDAQ:DELL) is not out of the woods and has more work to do, there are signs of a turnaround and improved focus on profitability vs. growth. While risk remains given limited visibility and overhang from SEC investigation, after 5 qtrs of disappointing results, the firm senses that the situation has bottomed. Though it may take time to show sustained improvement, they see favorable risk/reward.

As the firm has noted in other cases (HPQ, SUNW), turnarounds in tech can lead to big gains, but they are rarely straightforward and investors must be early. While Dell doesn't meet all their turnaround criteria, they sense less "denial" from Dell. Further, any more missteps could result in mgmt changes at the top, which could also be a positive catalyst. While it's logical to compare Dell vs. HPQ, to them the issue has been Dell vs. Dell. In firm's view, Dell got too big and wasn't ready for the next phase. Moreover, Dell chased revs for the sake of revs, moving away from its mantra of balancing growth/profit/liquidity.

After 7 est. cut in past yr, the firm is raising ests but caution that they think they're directionally right, but there may still be volatility. Firm is raising EPS for FY07 from $1.05 to $1.17 and for FY08 from $1.20 to $1.45. If firm's thesis is right, the stock has potential upside to their $35 target (20x CY08 EPS), though turnarounds often perform better than one thinks.

- Prudential thinks the story has just begun and believe that Dell only partially benefited from its key margin drivers in the OctQ - 1) stable PC pricing and a richer product mix, 2) server/storage product cycles, 3) reduced component costs, and 4) services expansion. Firm expects to see more margin leverage in coming quarters as these initiatives to improve profitability gain traction.

They are modeling Dell to increase operating margin by another 100 bps over the next 2-3 quarters, and then turn further cost reductions into more aggressive pricing to win share.

Firm continues to believe Dell has the best chance in their universe to post upside to consensus estimates over the next several quarters. They are increasing their street high FY08 EPS estimate by $0.11 to $1.61, and are raising price target to $31 frm $28. Dell remains firm' top pick.

Firm's matrix suggests an operating margin snapback above 8% (above 7.5% including FAS123) is needed to make the argument for owning the stock. They are not convinced margins will approach the recent annual peak of 8.6%. Maintains Neutral.

- JP Morgan notes Dell's revenues of $14.38 billion were a bit light relative to their estimateof $14.45 billion, but EPS of $0.30 exceeded our estimate of $0.24. Without any significant changes to the business model, it appears Dell will choose to continue to harvest profits, and growth may remain tepid for quite some time.

Pricing discipline apparent. Part of the upside was clearly due to Dell's movement away from low-end PCs, and this was the primary reason Dell's unit growth was only 3% compared with HP's 16% unit growth.

Move away from low-end PCs only partly explains the margin rebound. The loss of the Intel subsidy could have been a driver of Dell's margin shortfall last quarter, while this quarter's improvement may have been driven by price concessions from AMD. HP may seek to gain similar price concessions. In firm's view, these concessions for Dell are likely to be matched for HP given the company's similar size and higher AMD-based volumes. As a result, they believe the long-term relative profit improvement for Dell remains questionable. They believe this will either show up as lower margins, or the relative cost compression will hold back the company's overall growth rate.

Even off of upwardly revised estimates, Dell is trading at 17x JPM's calendar 2007 EPS ex-options estimate. Firm believes this valuation is too rich given the uncertainty over future margin levels and tepid growth, and they continue to prefer exposure to Overweight-rated HP.

- Morgan Stanley notes they remain owners with a 12-18 month time horizon; buy on dips. Preliminary numbers better than market anticipated and stock should trade up on news. Longer-term, evidence suggests management is driving business growth and profitability in a more balanced manner. If execution continues, they still believe $1.84+ normalized EPS is doable.

Short-term focused clients should trim into strength. While last night's report was encouraging, the SEC investigation likely remains an overhang on the stock between now and year end. The next meaningful step-up in operating margin is also a couple of quarters out. With these headwinds and lack of a near-term catalyst, the stock is likely range bound near-term. Firm looks to buy on dips to own into Vista-related growth, Analyst day and improved margin catalysts in early 2007. Maintains Overweight and $30 tgt.

Notablecalls: I think DELL can trade briefly over the $27 level this morning but will close below that level. While I'm surprised by the margin upside I remain skeptical regarding additional margin expansion. Also, the news from DELL may put some additional pressure on AMD.